Real Estate

You can invest in real estate with the Tangible Real Estate Strategy or with the Real Estate Fund Strategy.

The Tangible Real Estate Strategy

Perhaps you cannot invest in securities because your income just barely covers expenses. You still might be able to invest in a house if ownership expenses are comparable to rent.

Shabby houses

The best real estate investment for most people is a shabby house. The cash requirement is low if owner-occupied and the potential for capital gains is high. The cash requirement is usually higher if not owner-occupied.

Income property is usually bought with a down payment of at least 30% to obtain the best interest rate, avoid the expense of mortgage insurance, and make the cash flow positive. A down payment of 20% or even 10% might be available on less favorable terms. Some pundits suggest the seller finance 100% of the mortgage and the agent accept a note for the commission, but sellers and agents willing to do this are rare.

To qualify for an owner-occupied loan, you probably will need to certify your intention to use the house as your principal residence for at least one year. After one year you can rent it out.

If you don't want to live in a shabby house for even one year, you can rent it out as soon as you make the necessary improvements. The cash requirement will usually be higher, but it is sometimes possible to assume the existing mortgage and acquire the house with little cash.

If you don't have the time or aptitude to manage rental property, you can hire a professional manager. Of course, this will reduce investment performance.

Real estate agents used to say a home is a safe investment. Economists used to say there might be local areas of price weakness, but there would never be widespread price weakness. The agents and economists failed to recognize the bubble that peaked in 2006, so should never again be trusted.

If house prices are in a bubble, it is better to postpone buying until the bubble bursts and prices have bottomed. This chart clearly shows the bubble. It also shows the average annual return was 5%, less the amount due to increasing house sizes, but it is possible to do much better:

One way to have a high rate of return is to buy a shabby house in a nice neighborhood, improve it, and resell it. Another way is to buy a shabby house on acreage in the path of growth, wait for the acreage to appreciate, and resell to a developer. The gain can be greatly enhanced by subdividing the acreage before the resale, but getting the necessary approvals can be maddening.

Making excessive improvements on the house will reduce the rate of return. If the house is in a nice neighborhood, anything beyond improving the house to neighborhood standards is a bad investment. If the house is on acreage, any improvement beyond making the house livable is a bad investment because the house will probably be torn down after the resale.

It is sometimes possible to raise cash with a home equity loan. To qualify, you will probably need to have occupied the house long enough for your equity to have increased substantially due to increased value of the land. It is unlikely your equity will have increased substantially due to your mortgage payments.

Capital gains tax when the house is sold can be avoided whether the house is occupied by the owner or by a tenant. If occupied by the owner, establishing residency requires living in the house for a minimum of two years. In 2016 a gain of up to $500,000 for a married couple or $250,000 for a single person would then be exempt from capital gains tax.

If the house is occupied by a tenant, capital gains tax can be avoided by selling the house in a tax-free exchange. A tax-free exchange results if the house is traded for other income-producing real estate of equal or greater value. The ideal exchange would be for shabby rental property, not necessarily a house, in a nice neighborhood or on acreage.

There is an alternate method of trading real estate called flipping, which entails buying a fixer-upper for a quick resale. Flipping is not suitable for retirement investing because it requires much cash, has serious tax consequences, and is unproductive when housing supply outstrips demand.

Personal experiences

I bought a house on two acres for $53,500, lived in it for a few years, and then rented it out for a few years. I sold it to the tenant, repossessed it when my note went into default, and lived in it again for a few years.

I obtained a home equity loan and bought a nearby house on two acres for $65,000. I invested $2,000 to make it livable and rented it out for a few years.

The lots were zoned for 11 residential units per acre. They were on unincorporated land, but were annexed by the city. The allowable units per acre were greatly reduced, which reduced the value of the land. In spite of this, the value of the land eventually quadrupled from its original value because the land was in the path of growth.

I subdivided each property into eight lots suitable for individual houses. This required approvals from neighbors and from many federal, state, and municipal agencies.

Eventually all approvals were granted but it took two years and cost $15,000, and there was the continuous possibility of disapproval for an arbitrary reason. The net cost was near zero because the highway district took some of the land for street widening and their compensation was generous.

After subdividing the properties, I sold them to a developer. My residence sold for $140,000 and there was no tax. The rental property was sold in a tax-free exchange for a fourplex worth $195,000.

The fourplex provided income, but I was more interested in capital gains than income so I sold it for $205,000. I received favorable tax treatment because the capital gain was long term.

The Real Estate Fund Strategy

Financial accounts, including accounts holding real estate funds, can transfer on death to named beneficiaries. You might be able to avoid the expense and complications of probate if most of your assets transfer on death, leaving only a small estate. Most states do not allow transfer on death for tangible real estate unless it is owned jointly, is owned as a life estate, or is in a living trust.

Finding the best strategy

If you cannot afford to buy a shabby house or you cannot find one at a reasonable price, you can invest in a real estate index fund instead. The most active in 2015 were IYR by iShares and VNQ by Vanguard. Both are highly diversified and have low expenses.

If your account is a 401k or a Roth 401k, it probably will not offer IYR or VNQ. If so, you can invest in a highly diversified real estate mutual fund if your account offers one. As a last resort, you can purchase IYR or VNQ through a Roth IRA account or a Regular brokerage account.

The charts for an S&P 500 index fund (SPY) and IYR are similar. There is no obvious connection of either to interest rates (IEF):

It might seem January Barometer trading signals, which are based on the S&P 500 Index, could be used for real estate funds. However, using January Barometer trading signals with IYR is inferior to a Buy&Hold strategy:

Use a 30-box threshold for real estate funds, as recommended on the signals page. A 30-box threshold has
historically outperformed the Buy&Hold strategy:

Buying and selling

The best time to buy is the first trading day before the 26th, except before the 16th in December. The best time to sell is the first trading day before the 7th (timing).

When in an uptrend, check for a reversal (-26% from the top of the uptrend) each month just before the optimum selling day. To reduce risk, sell out if a reversal occurred and suspend investment until a new uptrend begins.

When in a downtrend, check for a reversal (+35% from the bottom of the downtrend) just before an optimum buying day. Reinvest the proceeds if a reversal occurred.

Invest in subsequent months until a new downtrend starts. See the tranche table on the buy page to determine the amount to buy.

Options versus shares

In 2015 both IYR and VNQ had LEAPs (long-term options). The tests page shows the LEAPs have unusually low premium ratios, making them preferable to shares.

If your account will allow option purchases, buy options just out of the money in the most distant series. Covered call writers tend to make this strike relatively more active, so more likely to produce favorable execution.

When an option nears expiration, sell on the first trading day before January 7. Reinvest the proceeds unless the fund has developed a downtrend. To ensure you will not create a wash sale, postpone reinvestment until February.

Reducing taxes

In a Regular brokerage account, you can sell investments showing paper losses to establish tax losses. Selling will not establish tax losses in any kind of individual retirement account.

Sell on the first trading day before September 7. Reinvest the proceeds unless the fund has developed a downtrend. To ensure you will not create a wash sale, postpone reinvestment until October.

Selling in September is advantageous. You will have reduced your investment exposure during the weakest part of September, which is the weakest month of the year (timing).